Definition and Examples of Financial Data Analysis
How does financial data analysis work?
What does this mean for individual investors?
Definition and Examples of Financial Data Analysis
The process of financial data analysis involves reviewing financial statements to assess the financial position of an organization. Investors study income, expenses, liquidity, profitability, and other financial indicators to gauge the success of a business. Based on this knowledge, some investors hope to predict a company’s future performance.
Three of the most common financial statements are:
- Balance Sheet
- Income Statement
- Cash Flow Statement
These are the most commonly used financial reports, but there are other reports that investors can use based on their needs.
How does financial data analysis work?
Investors looking for companies use financial reports to understand the past and make informed decisions about investing in a company. By reviewing the financial details, you can see how the company’s financial information has changed over time and how it compares to competitors in the same industry.
Financial reports provide information that you can use to analyze financial ratios or perform financial calculations in an attempt to understand the company’s financial position. For example, you can calculate the price-to-earnings ratio using the earnings per share information from the income statement.
Balance Sheet
The balance sheet outlines the company’s assets and liabilities. Through this information, you can determine whether the company has high levels of debt in relation to its assets. By reviewing previous balance sheets, you may discover trends such as increasing reliance on debt or debt reduction. The balance sheet also includes a statement of shareholders’ equity, which explains the value of outstanding shares. This statement reports changes in the number of shares as well as other buying and selling activities.
Income Statement
The income statement, also known as the profit and loss statement, shows the amount of revenue the company generates and where that money is spent. Expenses are organized into categories such as operating expenses and cost of goods sold, helping investors determine where the company spends its money. The bottom line of the income statement shows net income, which is the amount remaining after all expenses are paid. The income statement indicates to investors whether the company is operating at a loss or not.
Cash Flow Statement
The cash flow statement records the inflows and outflows of cash for the company. Cash flow is critical, as running out of cash can lead to business failure. Cash flow differs from the earnings reported on the income statement. The income statement may include “expenses” that are not tied to cash flows (such as depreciation or amortization), so its profits may not provide enough detail about the company’s cash position. Therefore, it is important to assess the incoming and outgoing cash flows of the company separately from the figures found in the income statement.
What does this mean for individual investors?
Financial data analysis helps investors recognize a company’s financial condition to make informed investment decisions. However, it is important to consider several key points about the practice of using financial data:
- Each report represents a specific moment in financial data, and a company’s financial condition can change after the report is prepared.
- You can understand how the company’s financial condition has evolved over time by using more than one financial report.
- Many investors choose to learn how the financial reports of competing companies compare to the company they are studying.
- If you rely on financial data analysis, you should continuously monitor the company and the industry.
- Positive trends can change quickly and can sometimes signal problems.
The numbers you find in financial reports are just one part of the big picture. To gain more clarity about any company you are considering investing in, you also need a qualitative understanding of what is happening. This may require reading narrative descriptions, news reports, and other sources.
Note:
Financial statement analysis is an ongoing process for investors, not a one-time task.
You are not necessarily required to engage in financial statement analysis if you wish to invest. This practice is primarily considered for those who choose stocks, and you are not required to analyze and select individual stocks when investing. Instead, you can practice passive investing using index funds and passive ETFs. With this approach, you invest in the market as a whole rather than selecting individual securities (or relying on someone else to choose stocks on your behalf).
Key Takeaways
Financial statement analysis is the practice of reading company reports to learn more about the financial condition of the enterprise. Financial reports provide information you can use for calculations, ratio analysis, and trend analysis. Investors who follow a passive investing approach do not need to select individual stocks or analyze company reports. Try to look beyond the numbers available in financial reports and seek out major trends, competitors, management issues, and more.
Source: https://www.thebalancemoney.com/what-is-financial-statement-analysis-5197221
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